TIPS – short for Treasury Inflation-Protected Securities – are a type of US government bond that can help protect your assets against inflation. TIPS are indexed to inflation, so as prices rise, so does your investment principal, protecting any investment you’ve made in the bonds. With inflation still well above the Federal Reserve’s long-term target of 2 percent, TIPS can help you maintain your purchasing power.
Here’s what you need to know about TIPS and how they protect your money.
What are TIPS and how do they work?
TIPS are government bonds backed by the “full faith and credit” of the U.S. government, making them as risk-free as any traditional federal bond. Where they differ from other bonds is in the way they are structured to respond to the rate of inflation or deflation. TIPS respond to changes in the Consumer Price Index (CPI), a measure of inflation for consumers, as follows:
- If the index rises, indicating inflation, the principal amount of the bond rises by an equivalent amount.
- If the index falls, indicating deflation, the principal of the bond falls by an equivalent amount.
How does the inflation adjustment work? Unlike other typical inflation-linked bonds, TIPS pays a fixed interest rate. Instead, the client adjusts to the price index every six months. TIPS pay interest semiannually and are issued in terms of five years, 10 years and 30 years.
The amount you receive in interest and the bond’s capital return at maturity is affected by inflation and the fixed interest rate you receive.
For example, imagine you invested $10,000 in TIPS, paying a 1 percent return, and inflation increases at 5 percent, as measured by the CPI.
- Initially, you would earn $100 in interest annually on your $10,000 principal.
- After the inflation adjustment, your principal would increase to $10,500 and you would still earn that flat rate of 1 percent, and TIPS would now pay $105 per year.
However, it’s worth noting that the situation with deflation works in reverse, meaning your principal could fall over the life of the bond. However, at the bond’s maturity date, the U.S. Treasury promises to repay the adjusted principal or the original principal, whichever is greater.
That promise means you won’t lose the principal, but it doesn’t mean you’ll like the returns.
Like other government bonds, TIPS can be sold on the secondary market, but there is no guarantee that you will get what you paid for the bond. The U.S. Treasury’s guarantee that you will receive your full principal amount only applies to bonds that reach maturity.
So TIPS are structured differently than the very popular Series I bond, which adjusts the interest it pays in response to inflation, rather than the principal amount.
How to invest in TIPS
Investors looking to purchase TIPS can do so in a number of ways, although some are much easier than others:
- You can purchase TIPS on TreasuryDirect, the source for investors to purchase directly from the U.S. Treasury through auction. The interest rate is determined by the auction. If you buy from the Treasury, you can purchase TIPS in $100 increments, with a minimum purchase of $100. If you purchase through TreasuryDirect, you must hold them for 45 days. Auctions with different durations are only held in certain months.
- You can also purchase individual TIPS bonds through a bank or broker.
- A simpler solution for most investors is to buy an exchange-traded fund or mutual fund that invests in TIPS. These funds are highly liquid and easy to trade on an exchange when you are ready to buy or sell.
Investors considering buying TIPS should understand how they fit with the rest of their portfolio strategy and whether they make sense given the inflation outlook.
Advantages and disadvantages of TIPS
Although TIPS solve the problem of inflation, they also have other disadvantages that may be less obvious.
Benefits of TIPS
- Protection against inflation. The obvious reason to invest in TIPS is for inflation protection, since that’s what they were created for. The client will adapt to changes in the Consumer Price Index.
- Tradeable on an exchange. You can also sell TIPS on the secondary market at any time if you need liquidity, although there is no guarantee you will get what you paid.
- Low default risk. Backed by the U.S. government, TIPS are as safe as any other federal bond.
- Exempt from state and local taxes. All TIPS income is exempt from state and local taxes, allowing you to skip these additional taxes.
- Protection against deflation. TIPS also offers a form of deflation protection, so you will never receive less than the face value of the TIPS bonds you purchased at maturity.
Disadvantages of TIPS
- The director could refuse in the meantime. If deflation occurs, TIPS may fall in value, meaning you may not be able to sell them for what you paid.
- Lower rates in low inflation climates. TIPS will generally pay less than comparable government bonds in low inflation environments. The reason: the market incorporates the costs and potential benefit of inflation into the fixed interest rate it is willing to accept.
- CPI may underestimate actual inflation. TIPS are repriced based on inflation as defined by the CPI, and the CPI may not accurately reflect the inflation experienced by consumers. The result is that you still lose actual purchasing power.
- Interest and principal adjustments are taxable in the year received. You pay taxes not only on the interest income, but also on the principal adjustment at normal income rates (which are generally higher than the rates on dividend income). It can be frustrating to have to pay taxes on the principal adjustment because you may not have actually realized that gain and it may still be tied up in the bond. So you will have to submit the money for taxes, even if you have not paid it yet.
In short
TIPS provide a solution for investors concerned about the specter of inflation while investing in bonds, which otherwise may not yield enough to keep up with rising prices. But they are not without some protection costs, namely underperforming returns in low-inflation environments.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
